Last summer, Richard A. Posner, a federal appeals court judge, issued a surprising and prescient dissent. Executive pay is out of control, he said, and the marketplace cannot be trusted to rein it in.

Judge Posner is a conservative with libertarian leanings, and he is a leader of the law and economics movement associated with the University of Chicago. He often relies on economic analysis in his judicial decisions, and he believes that many questions are best sorted out by the marketplace.

But corporate America has insulated pay decisions from market discipline, Judge Posner wrote. “Executive compensation in large publicly traded firms often is excessive,” he added, “because of the feeble incentives of boards of directors to police compensation.”

The Supreme Court will hear the case this fall, as anger over huge bonuses paid to the executives of failing firms continues to grow. The case, Jones v. Harris Associates, may turn out to be the court’s first significant statement on the corporate culture that helped lead to the Great Recession.

The case arose from the enormous fees mutual funds pay to their investment advisers. A three-judge panel of Judge Posner’s court, the United States Court of Appeals for the Seventh Circuit, in Chicago, threw out a lawsuit brought by the investors in three Oakmark mutual funds who said the funds had overpaid their investment adviser, Harris Associates.

The panel decision, written by Chief Judge Frank H. Easterbrook, another leader of the law and economics movement, said the marketplace can be trusted to regulate fees. Judge Posner, dissenting from the full court’s decision not to rehear the case, said competition had not been effective in the keeping compensation under control.

Before last year’s market collapse, the mutual fund industry held more than $11 trillion in retirement and personal savings, and it paid advisers perhaps $100 billion in fees.

Mutual funds are odd enterprises. They are typically formed and run by their investment advisers, which select the fund’s board of directors. That board then negotiates the adviser’s fees.

Here is how Warren Buffett analyzed the situation in his 2003 letter to shareholders: “Year after year, at literally thousands of funds, directors had routinely rehired the incumbent management company, however pathetic its performance had been. Just as routinely, the directors had mindlessly approved fees that in many cases far exceeded those that could have been negotiated.”

The plaintiffs in the case before the Supreme Court claimed that Harris Associates had charged their funds twice as much as it charged its unaffiliated clients, like pension funds.

The Oakmark funds paid Harris Associates 1 percent of the first $2 billion in assets; independent clients were charged roughly one-half of 1 percent of the first $500 million. One percent of a billion dollars is nice work if you can get it.

“Mutual funds rarely fire their advisers,” Judge Easterbrook acknowledged. But, he continued, “investors can and do ‘fire’ advisers cheaply and easily by moving their money elsewhere.” A 2007 study from John C. Coates IV and R. Glenn Hubbard supported this conclusion, finding that mutual fund fees are kept in check by the movement of investors’ money.

But a brief supporting the plaintiffs filed in the Supreme Court by three economists, Ian Ayres, Robert E. Litan and Joseph R. Mason, questioned that study. New research in behavioral economics, the brief said, showed that most investors have a very poor grasp of rudimentary truths about probability and a disproportionate aversion to taking losses.

Mutual fund investors thus tend to look at past performance rather than fees. And they have a tendency to sell winning investments too early and hold losing ones too long.

Even if mutual fund investors could be counted on to act rationally, the economists’ brief said, they do not have ready access to the information they need to make sensible choices.

Instead of counting on investor behavior to keep fees in check, the brief concluded, courts should look to how much advisers charged independent clients like pension funds. A supporting brief from the federal government made the same point.

But Judge Easterbrook questioned the value of such comparisons. The two kinds of clients, he said, may have different needs. In its brief urging the Supreme Court not to hear the case, Harris Associates added that the Oakmark funds had outperformed “virtually every fund in their peer groups.”

Still, the tide seems to be turning toward skepticism about outsize compensation. In April, a month after the Supreme Court agreed to hear an appeal from Judge Easterbrook’s decision, the federal appeals court in St Louis allowed a suit against another investment adviser, Ameriprise Financial, to go forward. It was the first ruling in favor of unhappy mutual fund investors suing over advisers’ fees since Congress imposed a fiduciary duty on advisers in 1970.

Judge Easterbrook said the law had only a minor role to play, requiring no more than making sure that advisers “make full disclosure and play no tricks.”

But when public sentiment, economic research and even Judge Posner argue for more vigorous judicial examination of whether compensation is fair, the Supreme Court may just agree.

Good article. The take away point is to check out what the actual expense ratio is for a mutual fund. There are plenty of good managers out there that don't charge an arm and a leg.

I doubt this case goes against Harris though. The Oakmark funds are good funds and their expense ratios are reasonable. Some funds have higher expenses because of what they invest in (international funds are a perfect example).

This is a little misleading though. When executive compensation is brought up most people think of CEO's of Fortune 500's. That is the compensation that is grossly out of line IMO. You have executives who have become very wealthy despite running their companies into the ground.

The panel decision, written by Chief Judge Frank H. Easterbrook, another leader of the law and economics movement, said the marketplace can be trusted to regulate fees. Judge Posner, dissenting from the full court’s decision not to rehear the case, said competition had not been effective in the keeping compensation under control.

Just pausing to note that said Judge Easterbrook is the brother of Gregg Easterbrook, better known on Page 2 of ESPN as the MMQB guy.

I'll probably start reading MMQB again this year. I wrote him for for a couple years as he went off the deep end, completely bugger nuts, on the Spygate thing.